Merchant Cash Advance and Small Business Lending Developments

Topics • • • Recharacterization Issues So. Fi Settlement Bank Partnership Update

Recharacterization • Merchant Cash & Capital v. Edgewood Group, LLC • Platinum Rapid Funding Group Ltd. v. VIP Limousine Services, Inc. • Standish v. P. Rodney Jackson & LAC, LLC (In re Albertson)

Recharacterization • Merchant Cash & Capital v. Edgewood Group, LLC • Footnote 5 • Transaction “looks substantially like a loan” • Fixed ACH transaction failed to specify the percentage of future receivables purchased

Recharacterization • Platinum Rapid Funding Group Ltd. v. VIP Limousine Services, Inc. • Repayment based on a percentage of daily receipts • Period of repayment was indeterminate • Any calculation of an interest rate would require “unwarranted speculation”

Authorization to Pull Credit • Heaton v. Social Finance, Inc. • So. Fi settles California class action for $2. 4 million • Obtained consent for “soft” credit pulls, but allegedly did both “soft” and “hard” credit pulls, in violation of the Fair Credit Reporting Act. • The FCRA applies anytime we pull a consumer credit report on an individual (such as the guarantor of a business loan or MCA).

True Lender Issues Bank partnerships must be structured to avoid a successful challenge that the Bank is not the true lender. A true lender challenges asserts that at the time the loan was originated, the lender on paper – the bank – was not the actual lender. Rather, the actual lender was some other entity, usually not a bank, that used the bank as a way to avoid usury limitations or licensing requirements.

True Lender Issues Some bank partnership programs, particularly those offering subprime consumer credit, have faced such challenges. A true lender claim is based on allegations that the Bank is not actively engaged in the partnership; the bank does not receive the benefits or take the risks of a true lender; and the partner receives the majority of the profits. If a true lender challenge is successful, the Partner could face significant penalties for failing to be licensed as a lender and the loans could be considered usurious in some jurisdictions.

Madden Muddies the Water Prior to the decision in Madden v. Midland Funding LLC, most courts that considered partnerships found that the bank was the true lender. In Madden, the U. S. Court of Appeals for the Second Circuit - which includes Connecticut, New York, and Vermont - has held that non-national bank entities that purchase loans originated by national banks cannot rely on the National Bank Act (“NBA”) to protect them from state-law usury claims.

Madden Muddies the Water The decision in Madden undermines the “valid when made” theory on which assignees have relied for many years. It also impedes the ability of national banks (and, by analogy, state-chartered banks) to sell the loan obligations they originate, thus reducing their ability to lend. A true lender challenges asserts that the lender on the loan documents is not the true lender at the time the loan was originated. A Madden challenge looks to whether the current holder of an obligation originated by a bank has the authority to continue charging the rates and fees available to the bank at the time those rates and fees are imposed.

Recent Bank Partnership Decisions In Beechum v. Navient Solutions Inc. , consumer-plaintiffs argued that, as California residents, interest could not be imposed on them at a rate that exceeded 10% per year absent some other authority (such as a California Finance lender license). The defendants countered that California law does not limit interest rates a bank may impose.

Recent Bank Partnership Decisions The court looked only at the face of the transaction to assess whether it falls under a statutory exemption from the usury prohibition and not look to the intent of the parties. Consequently, the court found that it would only look at the face of the transactions at issue to assess whether the loans were exempted from the usury prohibition. Because a bank originated the loans and was exempt from California’s usury cap, the court dismissed the lawsuit.

Recent Bank Partnership Activity In 2015, the Colorado attorney general filed suit against a financial company, Freedom Stores Inc. , which allegedly arranges closed-end loans with Military Credit Services for service members through a bank partnership arrangement with Bank of Lake Mills. Freedom settled with Colorado in May 2016 and agreed to restitution to consumers, a payment to the state, and to abandon the bank partnership model in Colorado.

Recent Bank Partnership Activity Colorado regulator takes the position that its laws apply to Colorado residents, and, thus, has actively challenged bank partnerships in the state. Marlette Funding and Avant have both been the subject of regulator inquiries on its bank program in Colorado regulator takes the position that consumer loans offered by online lenders in Colorado should not exceed the rates permitted to a supervised lender (i. e. 21% APR). The criminal usury cap in Colorado, which applies to commercial loans, is 45% per year.

Recent Bank Partnership Decisions In late June 2016, the Maryland Court of Appeals, Maryland’s highest court, affirmed in Maryland Commissioner of Financial Regulation v. Cash. Call, Inc. that a non-bank partner cannot promote loans originated by a bank unless the non-bank partner is licensed as a credit services business and the loans comply with substantive Maryland law. This decision does not apply to business-purpose bank partnerships.

Recent Bank Partnership Decisions Edwards v. Macy’s Inc. : Federal law preempted a lawsuit raising state law claims under an unfair deceptive acts and practices (“UDAP”) statute against a national bank and its non-bank partner. Edwards specifically attempted to rely on Madden in connection with her claims against Macy’s. The Edwards court distinguished its facts from Madden, noting that although Macy’s is not a bank or a subsidiary of a bank, Macy’s was acting on behalf of the Bank in carrying out the Bank’s business. The Edwards court concluded that “the language could not be clearer: Macy’s was to provide marketing, credit processing, collections and customer service related to (the debt cancellation program), and it was compensated for doing so. Macy’s was, therefore, conducting those activities on (the Bank’s) behalf. ”

Recent Bank Partnership Decisions To the extent that a bank partnership is structured as an arrangement in which the non-bank partner acts on behalf of the Bank in carrying out the Bank’s business, bank partnerships can certainly look to the language of the Edwards decision for the idea that bank partnership arrangements should be treated differently than the sale of defaulted debt to a non-bank debt buyer (which was the form of the transaction in Madden). By partnering with non-bank service providers, banks can market services, generate loan volume, and reach customers that they may not otherwise be able to reach, especially in an online environment, thus allowing banks to fully exercise their federally-granted powers to act as a lender.

Recent Bank Partnership Decisions Commonwealth of Pennsylvania v. Think Finance: Court declined to allow the non-bank servicing partners of a federal bank to assert federal preemption as a basis to avoid a claim that the loans originated by the bank - and subsequently purchased by the non-bank partners - were usurious.

Recent Bank Partnership Decisions The Kane court noted that the U. S. Court of Appeals for the Third Circuit, which includes Delaware, New Jersey and Pennsylvania, distinguished, for purposes of preemption, between claims against banks and claims against non-banks. In In re Community Bank, the court found state law claims against a non-bank were not preempted by DIDMCA and the National Bank Act. On that basis, the Kane court held that even though the complaint contained state usury claims, those claims were not asserted against the bank, and thus, preemption did not apply. The Kane court concluded that In re Community Bank allowed state usury law claims to go forward against non-bank entities.

FDIC Developments In July 2016, the Federal Deposit Insurance Corporation (“FDIC”) issued proposed guidance for its member banks that work with outside partners to originate loans, including vendors involved in bank partnerships, supplementing the many financial institution letters the FDIC has issued on this topic. FDIC has also directed its member banks to consider: • What duties does the bank rely on the partner company to perform? • What are the direct and indirect costs associated with the program? • Is the bank exposed to possible loss, and are there any protections provided to the bank by the partner company?

FDIC Developments cont’d • What are the bank’s rights to deny credit or limit loan sales to the partner company? • How long will the bank hold the loan before sale? • Who bears primary responsibility for compliance requirements and how are efforts coordinated? • Is all appropriate and required product-related information effectively and accurately communicated to borrowers? • What procedures are in place to prevent identity theft and satisfy other customer identification requirements? • What other risks is the bank exposed to through the arrangement?

“Predominant Economic Interest” Test In Consumer Financial Protection Bureau v. Cash. Call, Inc. , a tribal lending case, the U. S. District Court for the Central District of California adopted the “predominant economic interest” test for determining “the true lender” in a case involving a tribal model of installment lending. The relevant language from the opinion follows: In identifying the true or de facto lender, courts generally consider the totality of the circumstances and apply a "predominant economic interest, " which examines which party or entity has the predominant economic interest in the transaction. Emphasis added. Consumer Fin. Prot. Bureau v. Cash. Call, Inc. , (C. D. Ca. 2016) 2016 U. S. Dist. LEXIS 130584, at 17 -19. THIS IS A FICTION

“Predominant Economic Interest” Test To date, we have seen this “predominant economic interest” test pop up in one other lawsuit that the court cites – Spitzer v. County Bank of Rehoboth Beach. In Spitzer, the court noted that “(w)hile we have no quarrel with the federal regulatory guidelines that define a lender, we disagree with respondents' contention that simply because written documentation provides that County Bank is responsible for such functions that such is dispositive of the question here. It strikes us that we must look to the reality of the arrangement and not the written characterization that the parties seek to give it, much like Frank Lloyd Wright’s aphorism that ‘form follows function. ’ Thus, an examination of the totality of the circumstances surrounding this type of business association must be used to determine who is the ‘true lender, ’ with the key factor being ‘who had the predominant economic interest’ in the transactions. ” IT IS A CONSUMER INSTALLMENT LOAN STATUTE CONCEPT

“Predominant Economic Interest” Test Two important findings in the California Cash. Call case. Court concluded that “absent an effective choice-of-law provision, the law of the borrowers’ home states applies to the loan agreements. ” “Absent an effective choice-of-law provision” is an important qualifier to the holding, as the existence of an effective choice-of-law provision would mean the governing law designated in the loan agreement should apply.

“Predominant Economic Interest” Test Second, another interesting item in the Cash. Call case appears in Footnote 8: The CFPB apparently contends that the Court should find that Western Sky loans made to borrowers in New Mexico and Colorado are void under those state’s licensing laws, even though Cash. Call held a license to make loans in those states. The CFPB appears to rely on the fact that Western Sky was not licensed in those states. The Court finds that the CFPB’s position is disingenuous in light of its argument that Cash. Call, not Western Sky, is the true lender.

“Predominant Economic Interest” Test In connection with any review of a bank partnership, note what licenses the non-bank partners hold to engage in brokering or marketing, purchasing, or servicing and collections. In the event that a court set aside a governing law clause and determined that a party other than the state or national bank was the true lender, a non-bank partner that adopted a “belt and suspenders” approach to compliance may, in fact, have been able to originate the challenged loan directly under licenses it holds.

Contact Information Katherine C. Fisher Hudson Cook, LLP 7037 Ridge Road Suite 300 Hanover, MD 21076 ( 410 -782 -2356 kfisher@hudco. com Catherine M. Brennan Hudson Cook, LLP 7037 Ridge Road Suite 300 Hanover, MD 21076 ( 410 -865 -5405 cbrennan@hudco. com Robert F. Gage Hudson Cook, LLP 3025 Boardwalk Street Suite 120 Ann Arbor, MI 48108 ( 734 -369 -4456 rgage@hudco. com